The transition to non-mining growth could be ugly

Shifting the engine of growth from resources promises to be a rough ride.
Photo: Glenn Campbell

by
Ed Shann

Both the Treasury and Reserve Bank have warned that Australia’s transition from mining-driven growth to faster non-mining growth may not be smooth. They are being optimistic. The adjustment could be ugly. I have argued for two years that the Reserve Bank should cut rates faster. The bank was too pessimistic in thinking the economy could not grow above trend without inflation rising. The bank should have been cutting rates more aggressively if non-mining growth was to accelerate sufficiently to compensate for the contraction in mining investment.

Rising mining output as projects come on stream will not offset the coming decline in mining investment. The resource-related sector will subtract from growth for several years. A large pick-up in non-mining output is therefore needed if the economy is to avoid slowing sharply.

The resource-related sector makes up 18 per cent to 20 per cent of the economy and has been growing so fast it has produced about 2 per cent of our recent economic growth. The rest of the economy has been close to recession and growing at only 1 per cent to 2 per cent a year.

Mining investment and capital imports are already falling and that fall will accelerate as existing projects under construction are completed. The recent ABS capital expenditure survey suggests a fall of 15 per cent in nominal mining investment and 10 per cent in total investment in 2013-14, if we compare the last survey with the same survey a year ago. The Bureau of Resources and Energy Economics (BREE) suggests even sharper falls in the value of mining projects under construction in following years. Mining investment could fall from a peak of 8 per cent of output back to its average of around 2 per cent of output in a short time, unless new projects are committed.

That shrinking feeling

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Mining companies are also cutting costs of existing output as commodity prices fall. This means additional contraction in mining service firms providing maintenance and production inputs.

Next year, the resource-related sector may add nothing to output growth, and in following years seems likely to subtract from growth. It was hoped investment in mining would decline gradually and this would be offset by rising mining output as new projects came on stream. That is no longer likely. Mining investment is likely to subtract 1 per cent a year from output growth from 2014-15 and on BREE estimates new projects will add only about 0.5 per cent a year to growth.

The swing is thus from the resource-related sector adding 2 per cent to output growth to it subtracting from growth in a year’s time. The non-mining sector is growing at only 1 per cent to 2 per cent a year and, to get aggregate growth anywhere near trend, it needs to accelerate sharply to 4 per cent plus annual growth.

Even if rates are cut further and the Australian dollar falls, the lags suggest a period of well-below-trend growth is likely. Previous rate cuts are starting to work, but the housing recovery is weak as is non-mining investment. Recent low non-mining-sector demand growth means there is plenty of spare capacity and little need for new investment. The public sector is cutting back. Private consumption is growing, but seems unlikely to jump sharply. Households are still cautious about increasing debt, and unemployment will rise if growth is below trend. We can cut rates more, given underlying inflation is near the bottom of the target band.

Commodity prices outlook pessimistic

On top of this slowing in real output growth, falling commodity prices mean Australian real incomes will slow more sharply than real output. The same output will earn less foreign exchange. Professor
Ross Garnaut
has painted a very pessimistic outlook for falling commodity prices, based on Chinese growth rapidly becoming less resource intensive.

The Chinese switch to a less resource intensive economy is likely to be slow and could involve cutting high-cost domestic mining output. Demand from the rest of Asia will continue to grow and resource-intensive industry will move from China to surrounding nations. I am therefore less pessimistic than Garnaut, but commodity supply is increasing rapidly and even if demand just slows, prices will fall. The fall could be sharper than the budget assumes.

Australia thus faces a double challenge. Resource-related real output is likely to be subtracting from growth, and falling commodity prices will reduce our income further. As many have pointed out, Australia needs to lift competitiveness and encourage resources to move into more efficient uses. We also need to boost domestic demand by cutting rates and hope the dollar falls further. To do all this while keeping inflation restrained will not be easy.